What differentiates an individual savings account (ISA) from other types of accounts is the fact you don’t pay have to tax on the returns you might make with the money you have in it. What happens in an ISA, stays in an ISA.
That remains true regardless of how much money you may accumulate in an ISA over time or how big your profits may get. It’s a tax benefit that gets better and better the more you save.
It’s why I struggle to understand why most ISAs in the UK are of the cash variety1 since savings rates are at pitiful levels and have been for many years. But with inflation rising, it’s even more perplexing.
Why? Because inflation chips away at the value of the pound in your pocket, as we’re all increasingly learning. So it also chips away at the purchasing power of your savings. And the only way to overcome that is if your capital grows at a rate that outpaces inflation with a higher return than you’re able to get on your cash savings.
How? We believe the best chance of inflation-beating success is to take some risks with your money while also managing those risks with an appropriate investment strategy.
That is where a stocks and shares ISA rather than a cash ISA can help. (Full disclosure: at Vanguard, we only offer stocks and share ISAs).
Yes, cash does have a key role to play in the finances of every household. As a financial planner, I believe strongly that having enough cash to cover at least three months of outgoings is sensible contingency planning. So, if you don’t have this, wait until you do before you start investing.
But, according to the latest government figures2, cash ISAs account for £270 billion of Britain’s savings, with £44 billion added to them last year alone. I doubt all of this is rainy-day cash, so I suspect a lot of it is just wasting away, left to the mercy of inflation.
To illustrate that, consider how even low levels inflation can have outsized negative effects on the value of your money over time. Here is some quick maths: did you know that just 2% price inflation per year for the next 35 years would, in total, result in a 100% increase in prices over that period? In other words, it would mean £1,000 of today’s money being able to buy £500-worth of goods and services.
Indeed, the Bank of England’s inflation calculator shows it took just 25 years for this to happen in the period up to 2021, when annual inflation actually averaged 2.8%.
So imagine the extra negative impact now that inflation has risen higher. Better still, look at the chart below, which shows the approximate return from deposit rates3 – both before and after inflation – since 1988.
What's clear from the lower line is just how much the return on cash has been eroded, even though inflation stayed depressed for much of the period. Judging by the way the line dips at the end, the erosion is also accelerating as the effects of the more recent and more elevated price pressures start to come through.
How £10,000 in cash savings might have evolved, before and after the effects of inflation
Past performance is not a reliable indicator of future returns. Cash returns illustrated by ICE Libor 3-month sterling rate; inflation by the UK Retail Prices Index. Source: FactSet as at 31 December 2021.
Time to re-evaluate?
All of which leaves you, the saver, with reason to ponder whether investing in a cash ISA is worth it. After all, you might be getting a tax saving on your interest but with rates as low as they are, this saving is likely to be virtually negligible4. Making matters worse, as we have shown, the value of your money is being eroded by inflation over time.
With a stocks and shares ISA you’re taking on more risk – because markets can go down as well as up. But you are potentially getting a better return too. A hypothetical annual return of 5%, for example, would have enabled the £10,000 referenced in the chart above to have grown to a nominal £30,000 over the same period (that’s before inflation).
What’s more, actual long-term stock market returns in real (inflation-adjusted) terms have consistently been positive for a very long time, The chart below illustrates this, with a representative global portfolio of shares that goes back more than 40 years. Whichever year is chosen, the real annualised return over 20 years is positive. (Note: this is before costs, but more on that later).
Real global equity returns have been positive in recent decades
Past performance is not a reliable indicator of future results. Notes: The chart shows the real, annualised 20-year returns of the MSCI World Index for UK-based investors, at monthly frequency. The sample period is 31 January 1979 to 31 October 2021. Sources: Vanguard calculations in GBP, based on data from Bloomberg and the OECD.
So, if you’re already covered for emergency cash funds, maybe it is time to consider a stocks and shares ISA for your future savings instead of (or in addition to) your cash ISA.
Under current rules, every adult in the UK can save up to £20,000 per year in an ISA and they can split that allowance across different types of ISAs too. So you could easily have a stocks and shares ISA and a cash ISA.
You can also transfer money between different types of ISA. So if you’ve already built up some savings in a cash ISA, there would be nothing to stop you moving part or all of that money5 into a stocks and shares ISA, if you wanted to.
Just remember not to initiate a transfer too close to the tax year-end on 5 April if you haven’t yet taken up your full 2021-22 ISA allowance and intend to pay more into your ISA before then. In this case, just to be on the safe side, we suggest you pay in any remaining money prior to initiating your transfer.
When choosing your stocks and shares ISA provider, remember also to look at how much they charge for the privilege of investing your money and the range of low-cost funds that they offer. The lower the costs, the greater your chances of investment success.
1, 2 The latest available government data show that 76% of the 11.2 million adult ISAs subscribed to in 2018-19 were cash ISAs.
3 As a proxy for this we employ an industry yardstick that banks use when lending to each other.
4 Assuming it even exceeds your annual non-ISA cash savings allowance in the first place, which is 2021-22 was worth up to £5,000. For more, see the HMRC web page Tax on Savings.
5 There is less flexibility when it comes to transferring money invested within the current year. In this case you would have to move all of it when transferring to a different ISA provider.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The eligibility to invest in either ISA or Junior ISA depends on individual circumstances and all tax rules may change in future.
If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described in this document, please contact your financial adviser.
This article is designed for use by, and is directed only at, persons resident in the UK. The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
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